Volatility reigns supreme

Fear is finally starting to take off; the Chicago VIX index is back at levels seen in June when the market had a fairly solid pull back.

- Volatility rises to June levels

- Time to the debt ceiling deadline: 8 days

- Bond short-term market inversion

Volatility rising

At 20.45, the gauge has appreciated over 17% inside two full days of trading. CBOE VIX are reporting that today was the fourth busiest day in history and sixth time this year contracts topped 300,000.

This shows that once more risk premiums are increasing and investors are nervous. Exchange trade options and other forms of derivatives are seeing renewed vigour as investors look to hedge positions. Hedging will make trading interesting over the next week, particularly if these derivatives are triggered.

Put options are the most likely contracts to be triggered and if exercised the world markets could see a very large amount of physical share selling if managers decided to take up the contract. We would expect volumes in the opening and closing crosses to be amplified the longer the deadlock in Washington drags on and the more put options are triggered. The higher the VIX climbs the more traders will head to ETOs for speculation and hedging.

Debt ceiling: 8 days - impasse remains ironclad

Both President Obama and House Majority leader Boehner have been on the wires this morning; both spoke about the fact the US must pay their bills and both stated that it would be a catastrophe if the US was to default, even if it is a soft default.

However this is where the bipartisan support ends; the President reiterated that he will not negotiate on the Affordable Care Act and that he will not be held to ransom on concession demanded by House Republicans. Majority leader Boehner reiterated that affordability in the budget needed to be addressed and that passing a clean bill on the debt ceiling is unlikely.

What is clear is neither side is showing any leadership. So far the Republican Party has been losing the public relations battle, however more and more questions are being asked about the President’s leadership. He is the leader of the country; his inability to even construct some form of positive dialog is telling and is why analysts are now talking about the real possibility of a soft default as the impasse seems ironclad.

The government shutdown is here to stay and the debt ceiling is now eight days away – the volatility is only just beginning.

The bond inversion

The bond market is again the biggest mover from the impasse in Washington and the bond yield inversion trade is on. There have been several commentators suggesting that the safest place to be is US treasuries and for arguments sake they are correct, but it is which treasuries you are following that will govern that opinion.

US ten-year yields are holding at 2.65%, having nslid 35 basis points since the high in September. The flattening of the curve is due to the Fed not tapering on September 18 and investors had placed bets on a move in the Fed’s monetary policy. Ten-year bonds are relatively unaffected by the shutdown and debt ceiling as coupon payments will flow over the life of the instrument and one or two missed coupons can be recuperated.

Short-term debt however is not faring as well, and this is my argument. If the US was to default, T-bills are under real treat of not be paid. The yields on these products are completely inversely correlational to theatrical price.    

The T-Bill due on October 24 hit its highs yield since issuance; the bill due on October 31 has climbed to its highest yield as well. There is a real possibility that these two instruments will not be paid and the risk premium in the bond yields is reflective of that fear and reflective in the VIX. This political impasse is far from over and is only going to get worse in the interim.

The ‘if’ now is what the key dates are if a default eventuates and what happens to coupon payments and bond yields. UBS talks about November 15 as the major default date.

The T-Bills in October, coupled with a handful of social security and Medicare payments, will see about $19 billion in repayments going out by the end of the month. 

However, due on November 15 is an interest and debt repayment of $31 billion and that does not include that fact there are two social security and Medicare payments due on the second and the fourteenth for $24 and $13 billion respectively. If the US misses the November 15 payment the ten and 30-year treasuries will be affected; then we will see how ‘safe’ US treasuries are as the markets reacts to missed payments.

Ahead of the Australian open

Ahead of the open we are calling the ASX 200 down 39 points to 5111 (-0.76%). BHP’s ADR is suggesting the stock should fall some 24 cents to $34.46 (-0.7%) after rallying yesterday on China returning from its week long national holiday for Golden Week.  Make no mistake, the issues in the US are going to affect Australia; 35% of US treasuries are settled in Beijing with the next major hold of US treasuries being Tokyo. These two countries are the biggest drivers in our region and Australia’s number one and two export and import trading partners. The next week is going to be volatile, with one direction trade. 

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